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EC5310 – Problem Set 9

Please complete the following questions which will be discussed during next week’s seminar.

The number in parentheses refers to the question in the textbook (2e) the question refers to or is based on.

** Questions with asterisks will be presented as part of the group presentation.  Note, all members need to speak at some point.** 

1)[17-24]** Seger plc is an unlevered firm with expected annual earnings before taxes of £35 million in perpetuity. The current required return on the firm’s equity is 20 per cent, and the firm distributes all of its earnings as dividends at the end of each year. The company has 1.5 million ordinary shares outstanding, and is subject to a corporate tax rate of 28 per cent. The firm is planning a recapitalization under which it will issue £40 million of perpetual 9 per cent debt and use the proceeds to buy back shares.

a) Calculate the value of the company before the recapitalization plan is announced. What is the value of equity before the announcement? What is the price per share?

b) Use the APV method to calculate the company value after the recapitalization plan is announced. What is the value of equity after the announcement? (Note, the debt has yet to be issued). What is the price per share?

c) How many shares will be repurchased? (Use your answer to b)). What is the value of equity after the repurchase has been completed? What is the price per share?

d) Use the flow to equity method to calculate the value of the company’s equity after the recapitalization.

2)[17-23] Neon Corporation’s share price returns have a covariance with the market portfolio of 0.048. The standard deviation of the returns on the market portfolio is 20 per cent, and the expected market risk premium is 7.5 per cent. The company has bonds outstanding with a total market value of £30 million and a yield to maturity of 8 per cent. The company also has 5 million ordinary shares outstanding, each selling for £20. The company’s CEO considers the firm’s current debt–equity ratio optimal. The corporate tax rate is 28 per cent, and Treasury bills currently yield 6 per cent. The company is considering the purchase of additional equipment that would cost £40 million. The expected unlevered cash flows from the equipment are £13 million per year for five years. Purchasing the equipment will not change the risk level of the firm.

a) Use the weighted average cost of capital approach to determine whether Neon should purchase the equipment.

b) Suppose the company decides to fund the purchase of the equipment entirely with debt. What is the cost of capital for the project now? Explain.

[Hint, you do not need to calculate anything, you need to justify that your answer to part a is applicable to this instance]

3) [18-4] What is the impact of a share repurchase on a company’s debt ratio? Does this suggest another use for excess cash?

4) [18-16] Empirical research has found that there have been significant increases in share price on the day an initial dividend (i.e., the first time a firm pays a cash dividend) is announced. What does this say about the view that dividend policy is irrelevant? Explain.

5) [18-20]*** (Only to be presented if there are 3 members in a group) Eurasion Natural Resources Corporation currently has 2,400,000 shares outstanding that sell for £5.16 per share. Assuming no market imperfections or tax effects exist, what will the share price be after:

a) a three-for-two stock split?

b) an 8 per cent stock dividend?

c) a 20 per cent stock dividend?

Determine the new number of shares outstanding in parts (a) to (c).

6)** [18-21] The balance sheet for Severn Trent Plc is shown here in market value terms. There are 2.4 billion shares outstanding.

The company has declared a dividend of £0.61 per share. The equity goes ex dividend tomorrow. Ignoring any tax effects, what are the shares selling for today? Show that total dividends paid will be £1.464 billion. What will they sell for tomorrow? What will the market value balance sheet look like after the dividends are paid?

7)*** [18-22] (Only to be presented if there are 3 members in a group) In the previous problem, suppose Severn Trent plc has announced it is going to repurchase £1,464,000,000 worth of stock instead. What effect will this transaction have on the equity of the firm? How many shares will be outstanding? What will the price per share be after the repurchase? Ignoring tax effects, show how the share repurchase is effectively the same as a cash dividend.

8) [18-6] What are the real-world factors that would encourage firms to follow a high dividend policy? Review these factors and comment on their appropriateness for corporate financial decision-making.

Questions to consider in your own time:

X1) [18-1] Explain the difference between a cash dividend and a stock dividend.

X2) [18-3] How is it possible that dividends are so important, but at the same time dividend policy is irrelevant?

X3) [18-5] Explain the importance of taxes in dividend policy. In a world with taxes, would dividend policy be relevant to you even if you are a tax-exempt financial institution? Explain.

X4) [18-13] You are approaching retirement and are considering ways to minimise the tax bill from your investment portfolio. Assuming that you are only investing in equities within your country, what is the best way to maximise your after-tax investment return? Explain.